L2 - Time Value of Money

L2 - Time Value of Money - Financial Management Fall 2010...

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Financial Management Fall 2010 Lecture 2: Time Value of Money (TVM) Professor Erica Li Ross School of Business
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Roadmap for today ! Time value of money ! Four important variables & concepts " Future value (FV) " Present value (PV) " Return " What’s their relation?
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Time value of money ! TVM: $1 today is worth more than $1 promised at some time in the future ! Time value of money comes from the existence of investment opportunities that have positive returns
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Time value of money ! Money at different points in time has different value ! Cash flows at different points in time cannot be compared directly " Can we compare £1 with $1 without applying the exchange rate? ! To compare cash flows that occur at different points in time, we need to convert them to the dollar amount at the same point in time
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Future value (FV) ! Future value refers to the amount of money an investment will grow to, over some period of time at some given interest rate ! How much money will you receive next year if the (rate of) return is 10% and you invest $100 today? $100 + $100*10% = $110 ! $110 is called the future value (FV) of the $100 today at year 1 at (a return of) 10% ! $110 at year 1 is equivalent to $100 today at 10%
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FV in two periods ! How much do you get at year 2 (FV at yr 2) if " you reinvest the $100 and the interest earned during year 1 " and the return is also 10% from year 1 to year 2 FV 2 = 100*(1+10%)*(1+10%) = 100*(1+10%) 2 The payoff at the end of year 1
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Interest on interest !"# !"% ’()*+),-. %## %## %## %# /*!0(01! %# %# % /*!0(01! 2* /*!0(01!
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! You invest $100 for more than one period (a year, a month, …). If you earn interest on the interest accumulated from previous period(s), it is called compound interest. ! If you only earn interest on the original principal ($100), it is called simple interest . At yr 2, you receive $100+2*$100*10% = $120 What about at yr 3, yr 4, …? ! By default, we always use compound interest, unless
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This note was uploaded on 12/12/2010 for the course FIN 300 taught by Professor Mishra during the Fall '08 term at University of Michigan.

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L2 - Time Value of Money - Financial Management Fall 2010...

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